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    CEO Equity Incentives and Financial Misreporting: The Role...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management, 14.10 CEO Compensation 
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    Title:
    CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise.
    Practical Implications:

    The evidence documents an important role for financial statement verification in the way managers are incentivized. While the economic consequences of auditing have focused on improvements to the information environment and a lower cost of capital, this study broadens the role of auditing in the efficient functioning of firms. The link between auditor expertise and managerial incentives is an important one because CEO incentives have wide implications for managerial risk-taking.

    This study contributes to the CEO contracting-financial misreporting literature by providing an economic rationale for the inconsistent evidence in prior studies. The authors show that detection mechanisms such as auditor expertise mitigate the effect of equity incentives on misreporting by limiting the ability of managers to misreport financial statements.

    Citation:

    Jayaraman, S., & Milbourn, T. 2015. CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise. Accounting Review 90 (1): 321-350. 

    Keywords:
    auditor expertise, equity incentives, misreporting, earning management, CEO compensation
    Purpose of the Study:

    In the aftermath of accounting scandals at the turn of the century, many academics, regulators, and the media have questioned whether managerial compensation contracts are the culprits behind these acts of reporting transgressions. Greater equity incentives allegedly encourage managers to indulge in myopic acts aimed at maintaining stock prices and earnings at artificially high levels in the near term. A large literature in accounting and finance tests whether CEOs with equity-based incentives manipulate their financial statements. While the other studies differ in their research designs, empirical measures, and sample periods, none of them consider the role of detection mechanisms that would limit the ability of managers to successfully carry out any misreporting, assuming that equity incentives do indeed encourage misreporting. The authors posit effective auditing as one such mechanism, and argue that incorporating it in a CEO contracting-financial misreporting framework is likely to shed light on the preceding inconsistent findings. Following the auditing literature, the authors use auditor industry expertise to capture the effectiveness of auditing and examine how it affects the association between CEO equity incentives and financial misreporting.

    Design/Method/ Approach:

    The authors merged four databases: (1) data on lawsuits from1994 to 2004, (2) data on CEO equity incentives from ExecuComp, (3) data on auditor expertise from 2003 to 2007 from Audit Analytics, and (4) data on control variables from Compustat and IRRC. The final sample comprises 7,427 firm-year observations over the period 1994 to 2004, of which 201 firm-years of the sample involve a lawsuit concerning an accounting or other misreporting. These observations involve 87 unique firms.

    Findings:

    Controlling for previously identified determinants of CEO incentives, firms audited by an industry expert grant their CEOs an average of 14 percent more equity incentives than those audited by a non-expert. To further validate the inferences, the authors exploit variation across industries in the extent to which earnings matter for determining the stock price, and find that auditor expertise is positively associated with CEO incentives only in industries where earnings matter for stock price informativeness. Overall, these results are consistent with optimal contracting theories where equity-based incentives are, at least in part, granted by trading off the benefits of effort with the costs of financial misreporting.

    The authors find that AA firms audited by an expert auditor in the post-period experience an average of 17 percent larger increase in CEO incentives as compared to AA firms audited by a non-expert in the post-period. Overall, these time-series tests performed complement the cross-sectional inferences on the important effect of auditor expertise on CEO equity incentives.

    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Management